Working Paper: CEPR ID: DP6969
Authors: Peter Dunne; Harald Hau; Michael Moore
Abstract: Interdealer trading in the European sovereign bond market is characterized by low spreads and high liquidity. This paper examines whether the dealer-customer segment of the market also benefits from low spreads. Customers are smaller banks and buy-side financial institutions who request quotes from primary dealers. They generally do not enjoy access to the interdealer trading platform. Surprisingly, we find that customer trades are on average competitively priced and often occur inside the interdealer spread. Moreover, higher market volatility increases interdealer spreads more than customer spreads. The theoretical part of the paper develops a new dynamic model of dealer intermediation which captures the segmented market structure of the European bond market. The model explains differences in the volatility dependence of interdealer and customer spreads. The predicted inventory dependence of customer trade quality is also confirmed in the data.
Keywords: Adverse Selection; Dealer Intermediation; Market Segmentation; Spread Determination
JEL Codes: D4; G14; G2; G24
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| higher market volatility (G17) | increase in interdealer spreads (G19) |
| higher market volatility (G17) | customer spreads remain stable or decrease (G59) |
| dealer inventory management concerns (L81) | dispersion in customer prices relative to interdealer quotes (G19) |
| customer transactions (L14) | competitively priced inside interdealer spread (D41) |
| high price transparency (P22) | dealer intermediation does not deteriorate customer price quality (L15) |